Depreciation of tangible property — buildings, machinery, vehicles, furniture and equipment, even cell phones — as well as intangible property, such as patents, copyrights and computer software, in some situations, is allowed by the IRS and can be used to offset income from your business. Does your property meet these requirements?
- You own the property.
- Or you lease the property and make capital improvements.
- You use the property in business and for personal purposes. (In this case, you can only deduct depreciation for business use of the property.)
- The property must have a determinable useful life of more than one year.
However, not everything can be depreciated. For example, land is off the table: It doesn’t get used up and is not subject to wear and tear. Inventory is not depreciated either.
You depreciate an asset over time. When you place property in service to use in your business or trade or to produce income, that’s when depreciation begins. However, property stops being depreciable when you’ve fully recovered the property’s cost or other basis or when you retire it from service — whichever happens first.
There are different schedules for different items: For computers, office equipment, cars, trucks and appliances, the recovery time is up to five years; office furniture and fixtures work on a seven-year schedule. Residential rental properties can be recovered over 27.5 years, while commercial buildings and nonresidential properties can be recovered over 39 years, depending on the year you acquired them.
You need to know the initial cost of the asset and how long you can depreciate it for. There are three depreciation methods summarized below. Particular situations will dictate which ones are most appropriate for you.
- Straight line — depreciate the property an equal amount each year over its useful life.
- Accelerated method — take larger depreciation deductions in the first few years of the property’s useful life and smaller deductions later on.
- Section 179 deduction — deduct the entire cost of the asset the year it’s acquired. For the 2018 tax year, the deduction limit is $1 million. Think of this as accelerated depreciation. It is used mostly by new businesses in their first year.
And to ensure that you properly depreciate property, you need to consider:
- The depreciation method for the property.
- The class life of the asset.
- Whether the property is Listed Property (as defined by the IRS)
- Whether you’ve elected to expense any portion of the asset.
- Whether you qualify for any bonus first-year depreciation.
- The depreciable basis of the property.
Use depreciation to decrease your tax burden — you are lowering your overall taxable income. Depreciation doesn’t affect your company’s cash flow or its actual cash balance — it’s a noncash expense. However, before making any decisions, keep in mind that this is just an introduction to a very complex topic, and the provisions and methods described here are not applicable in every situation. Give us a call to discuss them further.